The economic disruption arising from the COVID-19 pandemic has taken centre stage as a driver of European bank ratings in 2020. It also provoked a strong response from policymakers eager to avoid any unnecessary constraint on banks' ability to extend credit to the real economy. This reflects two main factors: the previous years of strengthening has given some space to ease; and the depth of the crisis and its impact on the banking sector is hard to predict.

Aside from the huge fiscal support to the economy, the policy response for banks has been multi-faceted. For example, the widespread easing of requirements related to forbearance and the measurement of credit stress, softened capital buffer requirements in size and composition, and the temporary easing in EU state aid rules that at least until end-2020 reduce some of the restrictions on government support for key industries, including the banking sector. Specifically, should banks receive state aid and channel this to the real economy, this could be considered by the EU authorities as direct aid to the banks' customers, not to the banks themselves. Resolution authorities have also delayed some deadlines related to bank resolvability, such as those for bail-in buffer accretion.

As understandable as these measures are, they play into the already significant market doubts about many European authorities' willingness to avoid bail-outs if a major bank is close to failure. These doubts are informed by the current lack of resolvability of the vast majority of the larger European banks, the Italian bank bail-outs of recent years, and the persistent regulatory loopholes (such as in state aid rules). Market skepticism is even greater for systemic crises, where many investors consider it unlikely that resolution authorities would be willing to allow a series of systemic banks to fail and rely on largely unproven resolution tools, such as bail-in, to stabilize the situation--these failures could rather amplify financial instability.

Further Supportive Interventions Are Possible

While European economies are now recovering, significant setbacks are still possible, and the effect on bank asset quality and so capitalization is hard to judge. The ECB's July 2020 vulnerability exercise suggested that bank capitalization could hold up quite well under a base case of where most of the output lost is recovered by 2022--12.6% common equity Tier 1 (CET1) ratios on average at end-2022. However, the hit to bank capital would be far worse under an adverse scenario where the economy fails to rebound strongly--8.8% CET 1 ratios on average at end-2022. And either way there will be outliers.

We see that policymakers remain mindful about the corrosive effect of the long nonperforming loan (NPL) overhang after the last crisis—this simply served to undermine confidence in peripheral eurozone banks and delay their ability to write new loans. While this remains a somewhat long-range issue, we consider it likely that some kind of government-supported NPL alleviation measures will eventually emerge in the coming 12-24 months, at least in the markets where NPLs rise the most. While this could amount to state aid (depending on the applicable terms), this alone would be unlikely to challenge our view that extraordinary solvency support remains uncertain.

At this stage, we consider bank solvency support in the form of equity injections as unlikely, certainly under our base case. However, given weak bank profitability and basement-level stock valuations for most European banks, they could not readily tap the market for more equity. This could leave the authorities with the invidious choice to either undertake a "precautionary recapitalization" of one or more banks, or let them fail (and potentially use resolution tools if the conditions permit this) and risk a disruption in the cost and flow of credit to their economy.

Why Does Resolution Remain An Appropriate Analytical Base Case?

We have longstanding doubts about whether all EU member states are uniformly committed to not only delivering an effective resolution framework but to use it if a major bank fails, particularly while these banks are not truly resolvable--see Continued Bank Bail-Outs Stretch The Credibility Of Europe’s Resolution Framework, published Feb. 26, 2020. Policymaker flexibility in the face of the pandemic and its nature as a systemic crisis hardly alleviate these doubts, but neither do they amplify it.

When we say that extraordinary government support is uncertain in Europe, we are saying that it has become far less predictable than before and so rule it out as the base case underlying our ratings. Some countries--most notably Switzerland and the U.K.--were strong advocates of resolution from the outset and have made significant progress in bringing it to life. For the remainder, we think government support will become increasingly unlikely as their resolution frameworks mature, including procedural reforms to enhance consistency, and more banks become truly resolvable. We also acknowledge that, even with resolvable banks, any government's professed belief in resolution will be more likely to waver in a systemic crisis than an idiosyncratic one.

We do not see policymaker intent to purse resolvability as having been diluted by recent events--it was rather delayed in some respects. At best, resolvability will take several more years to achieve, and we see the 2024 deadline for eurozone banks to complete their bail-in buffers as an important milestone. If we saw targeted and demonstrably precautionary actions across a banking sector in the context of the current crisis, this wouldn't necessarily challenge our view.

In extremis, if we saw direct solvency support targeted at a failing bank, then we could still reflect this in our ratings. But it would add weight to the argument that some jurisdictions will continue to rely on bail-outs as a normal and predictable response to bank failures. We also look for any sign of rollback of the regulatory reforms or material dilution in how those rules are applied. Ultimately, while not our base case, we could reintroduce government support to ratings on systemically important banks in some countries if this appeared to be the appropriate analytical base case.

Policymakers Increasingly Acknowledge The Complexity In The EU Crisis Management Framework

The EU resolution framework is riven with complexity, in its construction and its application. At best, it impedes predictability of outcomes and investor comprehension. At worst, it may undermine the effectiveness of bank resolution plans and actions.

Predictability is already undermined by the fact that resolution frameworks are novel and relatively untested--there is no strong precedent to guide how decisions would be made in future. However, even within the EU, marked differences in national implementation and national insolvency frameworks lead to a fragmented picture and undue uncertainty.

The scope for improvement is widely acknowledged--by the resolution authorities themselves, policy think tanks such as Bruegel and the BIS Financial Stability Institute, and other market observers. It tends to center on the areas below. However, there seems to be little tangible progress for now.

Uneven creditor hierarchies.  For senior preferred creditors, there are important differences in national frameworks, which reflects that insolvency law remains national, and that some jurisdictions have taken steps to isolate confidence-sensitive uninsured deposits from other bail-inable senior liabilities (see chart 1). The ECB's long-held view is that it makes sense to prefer all deposits across the Banking Union.

Chart 1

Non-availability of useful tools unless the bank meets the public interest assessment.  Faced with a failed bank, European resolution authorities can deploy one or more of a range of resolution tools, but only if it is in the public interest to do so. And as many of them regularly point out, resolution is intended to be the exception not the norm. While a bank might be sizable, the public interest assessment (PIA) focuses on aspects such as whether the bank provides services that are critical to the functioning of the economy, its reliance on insured deposits, and its interconnectedness with the broader financial system. Banks that do not pass the PIA are likely to be liquidated if they fail.

Resolution tools include bail-in, but also a range of other strategies such as a sale of business, bridge bank, or temporary public ownership--that could be used with or without bail-in. While a full, bail-in led "open bank" resolution is (in most EU member states) likely to be retained for only the larger banks, straight liquidation could be disruptive and lead to sub-optimal outcome for creditors. (Under an open bank resolution, the operating entities undergo a recapitalization and maybe other interventions, but they continue to operate without any meaningful interruption.) By contrast, the FDIC (Federal Deposit Insurance Corporation) has repeatedly deployed purchase and assumption (that is, business transfer) strategies when it deals with even quite small banks, aided where necessary by funding from the deposit guarantee scheme.

It is moot whether the problem lies in the positioning of these tools behind the PIA, or the variability in each resolution authority's interpretation of the PIA itself. But either way, for investors it leads to strange outcomes in Europe where some tiny retail banks pass the PIA but other much larger ones do not (see chart 2).

Chart 2

Legal and regulatory fragmentation of the Banking Union.  Diverging outcomes for failed banks across the Banking Union stem in part from a lack of harmonization of national insolvency frameworks, together with the state aid loophole that allows governments to deploy "liquidation aid" where they are averse to imposing losses on senior creditors (see Italian Bailouts Show EU Authorities Walk A Tightrope While Banks Transition Towards Bail-ins, published July 4, 2017). The Single Resolution Board's role as only one of many decision-makers for Banking Union banks adds further complexity--a problem not faced by its peers in countries like the U.K., Switzerland, or Sweden.

Composition and size of bail-in buffers.  The EU resolution framework acknowledges that there is a swathe of non-GSIB banks--that is, the DSIBs--that could cause significant financial instability if they were subject to a liquidation. They are huge in number, and extremely diverse in their business and funding models, and therefore there is some natural variation in the authorities' preferred resolution strategies for these banks. However, the compromise underlying the calibration of loss-absorbing capacity in the June 2019 "banking package" created scope for extra complexity and variability.

• For banks with total assets of €100 billion or higher ("Top Tier Banks") and global systemically important banks (G-SIBs), the rules now require that banks generally build minimum requirements for own funds and eligible liabilities (MREL) of at least 8% of their total liabilities and own funds (TLOF).
• For banks below total assets of €100 billion, the calibration of MREL is a case-by-case assessment.
• Resolution authorities can request that a bank's MREL consist of fully subordinated bail-in debt. However, the framework permits banks to count material unsubordinated (preferred) debt in their bail-in buffers under certain conditions and if approved by resolution authorities. In this respect, the EU aligned its subordination requirements with the Financial Stability Board's TLAC (total loss-absorbing capacity) standard. However, none of the legislators or resolution authorities in other major jurisdictions globally have adopted this option--they insist on fully subordinated loss-absorbing capacity.

The result is that even though major banks across the EU could be targeted for the same resolution strategy--for example, a bail-in led, open bank resolution, which will likely require a full recapitalization--they could in practice have very different MREL buffers from each other, both in size and composition, parts of which may rank pari passu with senior operational liabilities.

Bank and regulatory disclosure remains incomparable and insufficient.  This is slowly improving, but investors often face significant guesswork when trying to understand a bank's resolution strategy, the size and composition of its buffer requirements, the prospects for its subsidiaries, and whether the institution is substantially resolvable or not.

Funding in resolution modelling opens up further scope for divergence.  Whereas the sizing of MREL is codified in the regulation, a recapitalized solvent bank can still fail due to illiquidity. The sizing of those liquidity needs and related resources is, however, potentially tricky. It relies on key assumptions, for example around the monetization of assets, and can require significant use of banks' own models, such as to determine likely deposit outflows. Many European jurisdictions are only now tackling this area of resolvability, and it seems far too early to conclude that substantial divergences will not occur.

Our Ratings Reflect Our View Of Banks' Likely Fates If They Fail

A bank's likely resolution strategy is central to whether we would give ratings uplift for ALAC

This is because additional loss-absorbing capacity (ALAC) uplift reflects the existence (current or prospective) not only of a substantial bail-in buffer, but also our view that the associated resolution strategy would likely ensure full and timely payment of the bank's senior preferred obligations. In this respect, our ALAC methodology does not favour or require open bank resolution, but rather looks at the likely outcome for senior creditors.

However, the use of the bail-in tool (or similar mechanism) to not only absorb losses but also substantially recapitalize a failed bank is a central feature of the strategies of banks that receive ALAC uplift. European resolution authorities maintain a differing stance on the size and type of institutions that would likely merit a bail-in-led resolution. For example, the Dutch, Swedish, and U.K. authorities target smaller, second-tier banks for this type of strategy, but the Spanish authorities seemingly would not.

While middle-way resolution strategies--such as the sale of business or bridge bank--could in theory avoid a default on all senior preferred liabilities, this is typically not an objective of the resolution authorities, who do not implement such strategies in a uniform manner anyway. Furthermore, we may have doubts that these plans are reliably executable, particularly where the authorities require a limited bail-in buffer.

Resolution strategies can change

The resolution authorities review regularly and on an event-related basis the preliminary PIA for each bank under its remit. As noted above, the PIA is the key determinant of whether the Single Resolution Board (SRB) would likely use resolution powers if that bank fails, and so the preferred resolution strategy and the MREL requirement. Irrespective of the preliminary PIA determination, when a bank actually becomes nonviable, the authorities' final PIA determination and decision on which (if any) resolution tools to use could differ, depends on the circumstances at that time. However, we see the preliminary decision as typically a good guide to the likely final outcome. This is particularly true where the bank has only a modest amount of MREL that would be insufficient to enable a full recapitalization.

In practice, we expect the authorities' preliminary PIA determinations and preferred resolution strategies for banks to rarely change. However, we recently took rating actions on two banks because we considered it likely that the SRB had changed its preferred resolution strategy for them, now targeting liquidation instead of a bail-in-led resolution. Our CreditWatch placements on Deutsche Pfandbriefbank and Hamburg Commercial Bank reflect that we may decide to no longer include ALAC uplift in their ratings, and that we could also withdraw the resolution counterparty ratings. We also continue to monitor whether the authorities' preferred resolution strategy for other European banks could change.

MREL building is set to remain uneven

For those European banks for which we see the likely resolution path as supportive, we continue to include a growing number of ALAC notches in their ratings. This reflects our forward-looking expectations about how fast and how far they will build ALAC over the coming two-to-four years, and our expectation that over time they will sufficiently address other potential barriers to an effective resolution. Banks' public statements and emerging track records of issuance may confirm or challenge our assumptions.

We now include ALAC uplift in our ratings on 44 banks in 13 European countries (see chart 3), up from 37 banks in those same 13 European countries in July 2019. Among them, by end-2019 the ALAC buffers for 39 European banks already exceeded the applicable threshold for one or two notches of ALAC uplift. A further five banks receive ALAC uplift already, but are still in the process of completing this ramp-up. The annexes to this report set out the ALAC thresholds that we apply for selected European banking groups and our current expectations for when they will achieve these threshold ratios.

Chart 3

There are many other systemically important banks in Europe beyond these names, but whether they also gain ALAC uplift depends on a number of factors. Over time, we expect to include ALAC notches on more banks, including Liechtenstein once the banks made headway on their MREL issuance, and possibly also in Iceland, which is currently implementing its resolution framework (see Icelandic Bank Resolution Act Completes The European Map, But Implementation And Effectiveness Remain Unclear, Sept. 1, 2020). However, some systemic European banks will likely never receive ALAC uplift. This may be because, for example, we see the resolution strategy as unsupportive, or we doubt that their bail-in buffer will include sufficient subordinated debt to exceed the applicable ALAC threshold, or we expect that they would benefit from some other support mechanism (such as from being a government-related entity, or institutional protection schemes for some mutuals).

Table 1a

Table 1b

Over the past six months, we have slightly revised down our ALAC projections for most European banks due to two factors:

• Lower projections for going-concern capital under our risk-adjusted capital (RAC) framework, in the light of expected losses or weaker earnings at many banks combined with risk-weighted asset (RWA) inflation. This affects the excess total adjusted capital that we include within ALAC.
• In a few cases, such as Sweden, banks have delayed their issuance plans in response to regulators' decisions to push back deadlines for bail-in buffer accretion.

So far, this has not fundamentally challenged the assumptions underlying bank ALAC notching. While spreads have not returned to pre-crisis levels, we continue to see the capital markets as hugely supportive of issuance by strong banks across all debt classes. However, this could still reverse, and in time we could take negative rating actions if a bank's ramp-up of ALAC appears likely to fall short or be materially delayed.

Related Criteria

• Methodology For Assigning Financial Institution Resolution Counterparty Ratings, April 19, 2019
• Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Deutsche Pfandbriefbank 'A-' Rating Placed On CreditWatch Negative On Resolution Strategy Uncertainty, Sept. 15, 2020
• Icelandic Bank Resolution Act Completes The European Map, But Implementation And Effectiveness Remain Unclear, Sept. 1, 2020
• Hamburg Commercial Bank 'BBB/A-2' Ratings Placed On CreditWatch Negative On Resolution Strategy Uncertainty, Aug. 27, 2020
• What's Next For Resolution Counterparty Ratings?, March 2, 2020
• Various Rating Actions On Swedish Midsize Banks As Resolution Regime Gains Effectiveness, Feb. 28, 2020
• Continued Bank Bailouts Stretch The Credibility Of Europe's Resolution Framework, Feb. 26, 2020
• Various Rating Actions On Finnish Midsize Banks As Resolution Strategies Crystalize, Feb. 19, 2020
• Slovenia's Draft Law To Reimburse Sub Debt Investors Doesn't Affect Our View Of The Resolution Framework's Effectiveness, Oct. 21, 2019
• Bail-in Debt Remodels The Risk Profile Of Bank Funding In Europe And North America, Sept. 26, 2019
• The Resolution Story For Europe's Banks: Life In The Halfway House, July 18, 2019
• EU Banking Reform Package: Enhanced Balance Sheets, Incomplete Market Integration, June 18, 2019
• Ending Too Big To Fail: Different Journeys, Different Destinations, April 4, 2019
• Increasing Disclosure Is Set To Shine More Light On Bank Resolvability, March 16, 2019
• An Illustrative Rating Path For A Systemic Bank In A Bail-In Resolution: RCR Update, July 26, 2018
• Proposed Backstop For The Eurozone Bank Resolution Fund Is Potentially Ratings-Positive, April 24, 2018
• To Fail Or Not To Fail: The Point Of Nonviability Is Unclear For European Banks, May 31, 2017
• Bank Resolution
• In Central And Eastern Europe: Many Unanswered Questions, May 26, 2017

Annex 1

Annex 2